Contemporary Corporate Finance International Edition 12th Edition Mcguigan Solutions Manual

Contemporary Corporate Finance
International Edition 12th Edition

McGuigan Solutions Manual
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finance-international-edition-12th-edition-mcguigan-solutions-manual/
Contemporary Corporate Finance International Edition 12th Edition McGuigan Solutions Manual
CHAPTER 3
EVALUATION OF FINANCIAL
PERFORMANCE
ANSWERS TO QUESTIONS:
1. The primary limitations of ratio analysis as a technique of financial statement analysis are:
a. Ratios are retrospective and do not directly incorporate forecasts of future performance
of a firm.
b. Ratios only indicate potential problem areas; they do not identify causes of problems.
c. A good financial analyst must select the set of ratios that is most appropriate for the type
of firm being analyzed.
d. Ratios do not provide absolute measures for evaluation; rather they must be analyzed
against some standard. The choice of an appropriate standard for comparison can
sometimes be a difficult one.
2. The major limitation of the current ratio as a measure of liquidity is the inclusion in the
current assets figure of some assets that may not be highly liquid, such as inventory and, in
some cases, accounts receivable. The quick ratio, which does not consider inventories,
helps to offset this problem.
Another limitation is the fact that it is a static (based on the balance sheet) measure of
liquidity, whereas liquidity is a dynamic (flow) concept. Also, the current ratio may be
easily manipulated by the firm. For example, a firm with a current ratio greater than 1x can
increase that ratio by using cash to pay off some current liabilities. End-of-year balance
sheet manipulation such as this is common among firms having current ratio constraints
imposed as part of their financing agreements.
3. Above: The firm is having collection problems, possibly because of too liberal a credit
granting policy, inadequate collection efforts, or failure to write off uncollectible accounts.
Below: The company may be unduly restrictive in granting credit and therefore it may be
losing some otherwise profitable accounts to competitors.
4. Above: The company may be carrying too little inventory and thus may be subject to
frequent and significant "stock-out" costs. A strategy of carrying a small inventory may
cause the company to lose customers.
Below: The company may have a lot of slow-moving or obsolete inventory. It may also
not be making use of efficient inventory management techniques.
© 2012 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from
the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.
3-1
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5. The fixed asset turnover ratio is subject to four major limitations in comparative analyses.
The ratio is sensitive to:
a. The cost of the assets at the date of acquisition.

b. The length of time since acquisition.
c. The depreciation policies adopted.
d. The extent to which fixed assets are leased rather than owned.
Each of these factors will differ from firm to firm, making meaningful comparative analyses
difficult.
6. The three most important determinants of a firm's return on stockholders' equity are net
profit margin (earnings after tax/sales), the total asset turnover (sales/total assets), and the
equity multiplier (total assets/stockholders’ equity).
7. Alternative accounting procedures can have a significant impact on the validity of

comparative financial analyses. Three of the most significant areas for disagreement
between firms are inventory valuation (LIFO vs. FIFO, for example), depreciation methods
(straight line, accelerated or MACRS depreciation), and the treatment of financial leases
(capitalized or not). Any one of these items can limit comparability between firms.
8. Inflation can impact the comparability of financial ratios between firms in a number of
ways. One important example is the existence of inventory profits in a period of rising
prices. If a firm uses FIFO, it will show higher profits (and a larger balance sheet inventory
figure) in times of rising prices than a firm using LIFO. Inflation also affects the cost of
fixed assets and the depreciation charged against these assets. Firms that own older assets
will tend to report higher profits than firms with newly acquired assets. The use of
replacement cost accounting can offset these problems.
9. The P/E multiple indicates how much investors are willing to pay for each dollar of current
earnings. With a greater level of risk, investors will offer less for a dollar of earnings
because of that risk. Also, the greater the growth prospects of the firm's earnings, the more
investors will be willing to pay for a dollar of current earnings.
10. Generally earnings quality is enhanced the greater the cash portion of earnings and the more
the earnings are composed of recurring, as opposed to non-recurring items. Balance sheet
quality is enhanced the greater the inclusion of tangible, as opposed to intangible assets.
Also, the more nearly the asset values reported on a balance sheet are reflective of their
actual market values, the higher the balance sheet quality.
11. A lower P/E ratio can be expected for a typical natural gas utility than for a computer
technology firm because the growth prospects are much lower for the utility. Offsetting this
to some extent is a lower perceived risk of the utility.
12. Write-offs of non-performing assets should increase the future profitability ratios (e.g.,
return on assets and common equity) since the firm’s total assets and retained earnings (part
of common equity) will be lower. It also should increase the financial leverage ratios
3-2
because retained earnings (part of common equity) will be lower. Over the long run, the
write-offs of non-performing assets should increase the market value of the firm’s equity
securities, because any proceeds from the sales of these assets can be reinvested in more
profitable assets (i.e., assets with higher expected rates of return).
13. a. The bank must have a lower equity multiplier than other banks in the industry, on
average. That is the bank is employing more equity (for a given level of total assets)
compared with other banks.
b. A low equity multiplier implies that the bank is following a fairly conservative financial
leverage policy, which would lead to lower required rates of return on its debt (kd) and
equity (ke) securities, all other things being equal. Hence, all other things being equal, this
should lead to higher bond and stock prices. However, the bank may be earning above-
average returns on its assets by investing in higher risk assets compared with other banks.
This would lead to higher required rates of return on its debt and equity securities and thus,
all other things being equal, lower bond and stock prices. The answer cannot be determined
without more information on the relative riskiness of the bank’s assets.
14. MVA (market value added) is equal to the present value of expected future EVA (economic
value added). EVA is the incremental contribution of a firm’s operations to the creation of
MVA.
3-3
SOLUTIONS TO PROBLEMS:
1. The stock of both firms likely is valued on the basis of the projected earning
capacity of the firm. Obviously, the earning capacity of the assets of Jenkins is not
impressive relative to depreciated cost of the assets the firm has in place. If Jenkins
were to liquidate, it is doubtful if the company would be able to sell its assets for their
book value because of their depressed earning capacity. In contrast, Dataquest's
earnings are not closely related to its tangible assets. For a software firm, these assets
are likely to be relatively small. The largest asset of a software development firm is its
human "capital". Having the copyright on a leading piece of software can generate
large projected earnings streams, and consequently a high market to book ratio.
2. No recommended solution.
3. Profiteers, Inc. 2006 2007 2008 2009 2010
ROI 17.64% 14.64% 13.20% 10.71% 12.10%
ROE 23.64 20.50 21.25 17.67 19.72
Industry Average
ROI 15.00% 13.97% 14.30% 13.10% 13.40%
ROE 21.30 20.26 21.02 19.78 20.50
In the face of declining profit margins and less than average efficiency of asset
utilization, Profiteers has maintained its ROE by using more financial leverage.
3-4
4. Cost of sales = 0.5($290,000,000) = $145,000,000
Inventory turnover (beginning of year inventory)
= $145,000,000/$25,000,000 = 5.8x
Inventory turnover (end of year inventory)
= $145,000,000/$30,000,000 = 4.83x
Monthly average inventory = $43,333,333
Inventory turnover (monthly average inventory)
= $145,000,000/$43,333,333 = 3.35x
Because of the seasonal nature of Palmer's business, the monthly average

inventory turnover is more indicative of the success of Palmer's inventory
management.
5. a. Return on equity = $600,000/$2,400,000 = 0.25 or 25%
b. Sales = $600,000/.10 = $6,000,000
Total asset turnover = $6,000,000/$4,000,000 = 1.5x
Equity multiplier = $4,000,000/$2,400,000 = 1.67x
Gulf combines a significantly higher than average profit margin (10% vs. 6%) and a
somewhat higher equity multiplier (1.67x vs. 1.4x) with a significantly lower than
average total asset turnover to achieve results that are greater than the industry
average return on equity (25% vs. 21%). However, the higher equity multiplier of Gulf
indicates a higher level of financial risk. This offsets, at least in part, the value of the
higher achieved returns.
6. a. Jackson's current ratio is 1.88x compared to the industry
average of 2.5 times. Jackson's quick ratio is 0.66x compared to an industry
average of 1.1x. Jackson has net working capital of
$750,000. Jackson's liquidity is considerably below that of the
3-5
industry average. Based on a comparison of the firm's current
ratio to that of the industry and the firm's quick ratio to that of the industry, there
is some evidence that Jackson may carry excessive or slow moving
inventory.
b. The company has an average collection period of 38.9 days
compared to an industry average of 35 days. The company's
inventory turnover ratio is only 1.73x compared to an industry
average of 2.4x. This provides additional evidence of Jackson's
potential inventory problems. Finally, Jackson's total asset

turnover ratio of 1.25x is below the industry average of 1.4x,
probably because of the inventory problems and the slightly
higher than average receivables balance.
c. The company's times interest earned ratio is 2.89x compared to
the industry average of 3.5x. The company's total assets to
stockholders' equity ratio is 3.2x compared to the industry
average of 3.0x. This slightly higher amount of financial
leverage and significantly lower interest coverage ratio suggest
that Jackson either pays very high interest charges relative to
other firms, is less profitable than the average firm or a combination
of both. In any case the firm appears to have more financial risk
than the average firm.
d. Jackson's net profit margin of 4.44% exceeds the industry
average of 4.0%. The company's return on investment of 5.56%
is only slightly below the industry average of 5.6%. Jackson's
return on stockholders' equity of 17.78% exceeds the industry
average of 16.8% because of the higher level of financial
leverage used by Jackson.
3-6
e. Jackson seems to be carrying excessive inventory, resulting in a
lower asset turnover. The company's liquidity position is also
weak (quick ratio). In spite of these areas for potential improvement,
the firm has outperformed the average firm in the industry and has assumed
more financial risk in doing this.

f. ROE = Net profit margin times Total asset turnover times
Equity multiplier
ROE = ($133,320/$3,000,000) x ($3,000,000/$2,400,000) x
($2,400,000/$750,000)
ROE = 0.1778 or 17.8%
The primary area for improvement is total asset turnover (especially inventories).
g. The biggest factor that can explain Jackson's lower P/E ratio relative to the
industry average is the higher amount of financial risk the firm possesses.
Also, Jackson could be perceived as having a lower growth potential than the
average firm, although there is no direct evidence presented in the data to
indicate this.
7. a. EAT = $12 million
EBT = EAT/(1 - T)
= $12 million / (1 -0.40) = $20 million
EBIT = EBT + I
= $20 million + $5 million = $25 million
Times Interest Earned = EBIT/I
= $25 million/$5 million = 5.0 times
b. Interest = EBIT/Times Interest Earned
= $25 million/3.50 = $7.14 million
Additional interest = $7.14 million - $5 million = $2.14 million
3-7
Additional debt = Additional interest/Interest rate
= $2.14 million/0.10 = $21.4 million
c. Additional debt = $2.14 million/0.12 = $17.83 million
As interest rates increase, the firm's debt capacity (as
measured by the times interest earned ratio) decreases.
8. Hoffman’s present debt ratio is 44.25% ($500,000 / $1,130,000). Hoffman could
borrow an additional $130,000 and still maintain its debt ratio at 50%:
0.5 = ($500,000 + X) / ($1,130,000 + X)

X = $130,000
If Hoffman borrows $130,000 on a short-term basis and invests this amount in inventory
and receivables, its current ratio remains above 1.5 times.
Current ratio = ($450,000 + $130,000) / ($200,000 + $130,000)
= 1.76
Therefore, Hoffman can borrow up to $130,000 without violating the terms of its
borrowing agreement.
9.
Forecasted Balance Sheet
Cash $128,500 Accounts payable $164,250
Accounts receivable 200,000 Total current liabilities $164,250
Inventory 164,250 Long-term debt $200,750
Total current assets $492,750 Stockholders’ equity $547,500
Fixed assets 419,750 Total liabilities
Total assets $912,500 and equity $912,500
3-8
a. Total assets = $3,650,000/4 = $912,500
b. Total debt = .40($912,500) = $365,000
Stockholders’ equity = $912,500 — $365,000 = $547,500
c. Current liabilities = .30($547,500) = $164,250
d. Accounts payable = $164,250
e. Current assets = 3($164,250) = $492,750
f. Fixed assets = $912,500 — $492,750 = $419,750
g. Accounts receivable = ($3,650,000/365)(20) = $200,000
h. ($492,750-Inventory)/$164,250 = 2
Inventory = $164,250
i. Cash = $492,750 — $200,000 — $164,250 = $128,500
j. Long-term debt = $365,000 — $164,250 = $200,750
k. Total liabilities and equity = $912,500
10. a. Return on stockholders' equity = 0.03 x
($20,000,000)/$10,000,000) x ($10,000,000/$4,000,000)
= 0.15 or 15%
b. Return on stockholders' equity = 0.05 x 2.0 x 2.5 = 0.25 or 25%
11. Credit sales = 0.8($40 million) = $32 million
Average daily credit sales = $32 million/365 days/yr.
= $87,671.23
Average accounts receivable = 45 x $87,671.23 = $3,945,205
3-9
12. a. EPS = EAT / (Average number of shares outstanding)
= $21,000,000/5,000,000 = $4.20
b. Price/earnings ratio = Market price/EPS
= $32/$4.20 = 7.6
c. Book value per share = (Common stock + Contributed capital in
excess of par value + Retained earnings)/(Average number of shares outstanding)
= ($5,000,000 + $20,000,000 + $55,000,000)/5,000,000
= $16
d. P/BV = $32 / $16 = 2.0

e. Addition to retained earnings = net income - dividends
= $21 million - $10 million = $11 million
f. Balance Sheet
Current assets $ 60 Current liabilities $ 20
Fixed assets, net 110 Long-term debt 40
Common stock ($1 par) 6
Contributed capital in
excess of par value 49
Retained earnings 55
$170 $170
13. a. 50 days = Accounts Receivable/($1,600,000/365 days)
50 days = Accounts Receivable/$4,383.56
Accounts Receivable = $219,178
b. Cost of sales = (1 - 0.35)($1,600,000) = $1,040,000
Inventory Turnover = 6 = Cost of Sales/Average Inventory
6 = $1,040,000/Average Inventory
Average Inventory = $173,333
3-10
14. a. Current ratio = $5,750/$3,000 = 1.92 (no change)
Quick ratio = ($5,750 — $2,000)/$3,000 = 1.25 (increase)
Debt-to-equity ratio = $4,750/$6,000 = 0.79 (no change)
b. Current ratio = $5,250/$3,000 = 1.75 (decrease)
Quick ratio = ($5,250 — $2,500)/$3,000 = 0.92 (decrease)
Debt-to-equity ratio = $4,750/$6,000 = 0.79 (no change)
c. Current ratio = $6,250/$3,500 = 1.79 (decrease)
Quick ratio = ($6,250 — $3,000)/$3,500 = 0.93 (decrease)
Debt-to-equity ratio = $5,250/$6,000= 0.88 (increase)
d. Current ratio = $5,750/$3,000 = 1.92 (no change)
Quick ratio = ($5,750 — $2,500)/$3,000 = 1.08 (no change)
Debt-to-equity ratio = $6,750/$6,000 = 1.13 (increase)
e. Current ratio = $5,750/$3,000 = 1.92 (no change)
Quick ratio = ($5,750 — $2,500)/$3,000 = 1.08 (no change)
Debt-to-equity ratio = $4,750/$8,000 = 0.59 (decrease)
15. a. No improvement in liquidity, because the cash that is raised is tied up in a very
non-liquid asset.
b. No improvement in liquidity, because the firm’s most liquid assets (cash and
marketable securities) are consumed. Even though the current ratio will increase,
liquidity will actually decline.
c. Yes, because the debt service on long-term debt is normally less than on short-
term debt. There is no immediate refinancing risk on long-term debt. More
cashflow will be available for other uses.
d. Yes, because non-liquid assets become liquid assets.
16. a. The current ratio will increase because of the current asset
increase.
b. The return on stockholders' equity will decline because of the increase in
3-11
stockholders' equity, assuming no immediate impact on profits from increasing
inventory.
c. The quick ratio will increase because of the cash balance
increase.
d. The debt to total assets ratio will decline because of the increase in total
assets.
e. The total asset turnover ratio will decline because of the
increase in total assets.
17. a. Return on equity = $2,000,000/$7,000,000 = 28.57%
b. Keystone’s net profit margin (8%) is significantly below the industry average
of 10%. Sales for Keystone are $25,000,000 ($2 million/0.08). Keystone’s total
asset turnover ratio is 1.5625x, compared to the industry average of 2.0 times.
Keystone has made up for these deficiencies by assuming considerably more
financial risk (equity multiplier of 2.29x vs. an industry average of 1.5 times).
Thus, overall Keystone’s return on equity is below the industry average of 30%
and its level of financial risk is higher.
c. Quick ratio = (Current assets - Inventories) / Current liabilities
= ($6 million - $3.2 million) / $3.5 million
= 0.80
18. Return on stockholders' equity = 18% = (EAT/Sales) x 1.0 x 2.0
EAT/ Sales = 9.0%
3-12
19. a.
Firm
A B C D
Total Asset Turnover 1.33x 1.33x 1.00x 1.04x
Net Profit Margin 0.15 0.05 0.15 0.12
Equity Multiplier 1.50x 1.50x 1.07x 2.40x
Return on Equity 0.30 0.10 0.16 0.30
b. Firm A appears to have few problems in comparison with the other firms.
Firm B has a very weak profit margin, indicating the need for corrective action to
control costs or to change the firm's pricing strategy.
Firm C has a low asset turnover, suggesting the existence of excessive
investments in fixed assets and/or short-term assets. The low equity multiplier suggests
that the firm has not made as much use of debt as the competing firms. This low
turnover and low equity multiplier have combined to give Firm C a lower than average
return on equity.
Firm D has a lower than average asset turnover and an average profit margin.
The high return on equity has doubtlessly been earned by assuming a very risky (debt-
heavy) capital structure. This heavy use of debt exposes the firm to substantial
financial risk.
More detail about the determinants of the net profit margin and the total asset
turnover ratio would be valuable. This information could be in the form of a Dupont
chart. Also, it would be useful to know if all firms use similar financial reporting
methods.
3-13
20. a. Current ratio = $3.0/$1.5 = 2x
Quick ratio = ($3.0 - $1.0)/$1.5 = 1.33x
b. Current ratio = ($3.0 - $0.25)/($1.5 - $0.25) = 2.2x
Quick ratio = ($3.0 - $1.0 - $0.25)/($1.5 - $0.25) = 1.4x
Both the current and quick ratios rise, even though real liquidity has declined
(cash balances are cut in half).
c. Current ratio = ($3.0 - $0.5)/($1.5 - $0.5) = 2.5x
Quick ratio = ($3.0 - $1.0 - $0.5)/($1.5 - $0.5) = 1.5x
Both the current and the quick ratios rise.
d. Current ratio = ($3.0 + $1.0)/$1.5 = 2.67x
Quick ratio = ($3.0 - $1.0 + $1.0)/$1.5 = 2.0x
Both the current and the quick ratios rise.
e. These examples illustrate how easy it is for a firm to manipulate its current
and quick ratios, if necessary. Consequently, conclusions based on an analysis
of these ratios should be viewed with caution.
21. Reduction in accounts receivable = $5 million (20 days x $0.25
million per day)
New total assets after stock repurchase = $95 million
New common equity after stock repurchase = $35 million
Debt ratio: Old = 60%
New = 63% ($60/$95)
Return on assets: Old = 5% ($5/$100)
New = 5.26% ($5/$95)
Return on common equity: Old = 12.5% ($5/$40)
New = 14.29% ($5/$35)
3-14
22. Forecasted Balance Sheet
Cash $104,000
Accounts receivable 1,096,000 Total current liabilities $1,200,000
Inventory 1,200,000 Long term debt 2,800,000
Total current assets $2,400,000 Total debt $4,000,000
Net fixed assets 7,600,000 Stockholders' equity 6,000,000
Total assets $10,000,000 Total liabilities and $10,000,000
stockholders’ equity
a. Profit margin on sales = 0.05 = $1,000,000/Sales
Sales = $20,000,000
b. Total asset turnover = 2 = $20,000,000/Total assets
Total assets = $10,000,000
c. Total debt to total assets = 0.4 = Total debt/$10,000,000
Total debt = $4,000,000
d. Current liabilities to stockholders’ equity = 0.2 = Current
liabilities/$6,000,000
Current liabilities = $1,200,000
e. Current ratio = 2 = Current assets/$1,200,000
Current assets = $2,400,000
f. Fixed assets = Total assets minus current assets
= $10,000,000 - $2,400,000 = $7,600,000
g. Quick ratio = 1 = ($2,400,000 - Inventories)/$1,200,000
Inventories = $1,200,000
h. Average collection period = 20 days
= Accounts receivable/($20,000,000/365)
Accounts receivable = $1,096,000 (rounded to the nearest $1,000)
3-15
Contemporary Corporate Finance International Edition 12th Edition McGuigan Solutions Manual
i. Cash = Current assets minus accounts receivable minus
inventories
Cash = $2,400,000 - $1,096,000 - $1,200,000 = $104,000
3-16
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a. The cost of the assets at the date of acquisition.

7. Alternative accounting procedures can have a significant impact on the validity of

book value because of their depressed earning capacity. In contrast, Dataquest's

3. Profiteers, Inc. 2006 2007 2008 2009 2010

ROI 17.64% 14.64% 13.20% 10.71% 12.10%

ROE 23.64 20.50 21.25 17.67 19.72

ROI 15.00% 13.97% 14.30% 13.10% 13.40%

ROE 21.30 20.26 21.02 19.78 20.50

Inventory turnover (beginning of year inventory)

Inventory turnover (end of year inventory)

Monthly average inventory = $43,333,333

Inventory turnover (monthly average inventory)

Because of the seasonal nature of Palmer's business, the monthly average

5. a. Return on equity = $600,000/$2,400,000 = 0.25 or 25%

b. Sales = $600,000/.10 = $6,000,000

Total asset turnover = $6,000,000/$4,000,000 = 1.5x

Equity multiplier = $4,000,000/$2,400,000 = 1.67x

higher achieved returns.

6. a. Jackson's current ratio is 1.88x compared to the industry

average of 2.5 times. Jackson's quick ratio is 0.66x compared to an industry

average of 1.1x. Jackson has net working capital of

$750,000. Jackson's liquidity is considerably below that of the

is some evidence that Jackson may carry excessive or slow moving

b. The company has an average collection period of 38.9 days

compared to an industry average of 35 days. The company's

inventory turnover ratio is only 1.73x compared to an industry

average of 2.4x. This provides additional evidence of Jackson's

potential inventory problems. Finally, Jackson's total asset

probably because of the inventory problems and the slightly

higher than average receivables balance.

c. The company's times interest earned ratio is 2.89x compared to

the industry average of 3.5x. The company's total assets to

stockholders' equity ratio is 3.2x compared to the industry

average of 3.0x. This slightly higher amount of financial

leverage and significantly lower interest coverage ratio suggest

that Jackson either pays very high interest charges relative to

other firms, is less profitable than the average firm or a combination

than the average firm.

d. Jackson's net profit margin of 4.44% exceeds the industry

average of 4.0%. The company's return on investment of 5.56%

is only slightly below the industry average of 5.6%. Jackson's

return on stockholders' equity of 17.78% exceeds the industry

average of 16.8% because of the higher level of financial

leverage used by Jackson.

lower asset turnover. The company's liquidity position is also

weak (quick ratio). In spite of these areas for potential improvement,

more financial risk in doing this.

ROE = ($133,320/$3,000,000) x ($3,000,000/$2,400,000) x

average firm, although there is no direct evidence presented in the data to

7. a. EAT = $12 million

= $12 million / (1 -0.40) = $20 million

= $20 million + $5 million = $25 million

Times Interest Earned = EBIT/I

= $25 million/$5 million = 5.0 times

b. Interest = EBIT/Times Interest Earned